Chapter 11

In In Re Lexington Hospitality Group, LLC, the United States Bankruptcy Court for the Eastern District of Kentucky thwarted a lender’s efforts to control whether its borrower could file bankruptcy. As a condition to the loan, the lender mandated that the borrower’s operating agreement have certain provisions that require the affirmative vote of an “Independent Manager” and 75% of the members to authorize a bankruptcy. The lender also included a failsafe veto provision that prohibited the borrower from filing for bankruptcy without the advance, written affirmative vote of the lender even if the borrower had obtained the vote of the Independent Manager and 75% of the members.

Janee Hotel Group formed Lexington Hospitality Group (LHG) and acted as its manager. Under LHG’s original operating agreement, Janee managed the business and affairs of LHG. The operating agreement did not address bankruptcy.

PCG also required LHG to include certain “Bankruptcy Restrictions” in its operating agreement, to wit: LHG may declare bankruptcy only so long as an “Independent Manager” authorizes such action, and then only upon a 75% vote of the members. The Independent Manager’s role was restricted to participating in bankruptcy matters and, when considering such matters, was required to weigh the costs/benefits of the decision on LHG, LHG’s creditors and 5532 Athens. Additionally, the operating agreement prevented LHG from filing bankruptcy “without the advance, written affirmative vote of [PCG] and all members of [LHG].”

Eventually, LHG filed for bankruptcy without satisfying the above requirements. Instead, Janee, as the sole manager of LHG, signed the filing resolution, which contained no vote by the Independent Manager or the other members, nor had LHG obtained PCG’s “advance, written affirmative vote” for the filing. PCG moved to dismiss the bankruptcy as unauthorized.

The court recognized that state law governs whether LHG is authorized to file for bankruptcy, but federal law governs whether the Bankruptcy Restrictions are enforceable as a matter of public policy. Generally, parties have the freedom to agree to the terms of an operating agreement; however, attempts to contract away the right to file for bankruptcy generally are unenforceable.

Here, the court found that Kentucky law authorized LHG to file bankruptcy, since filing bankruptcy is a business decision connected to the business affairs of a company and within the expansive decisional authority reserved to managers under the Kentucky limited liability company act. Turning to the Bankruptcy Restrictions, the court noted that LHG included these provisions in its operating agreement only because PCG required them as a condition to loan. The court found that the inclusion of an Independent Manager was “merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted.” While “[a] requirement that an independent person consent to bankruptcy relief, property drafted, is not necessarily a concept that offends federal public policy,” limiting the independence of that manager is problematic. One such limitation was that the Independent Manager needed to consider the interest of creditors and 5532 Athens when deciding on bankruptcy, a restriction that abrogated the Independent Manager’s fiduciary duty to LHG. Another constraint on the Independent Manager’s ability to act independently was that, notwithstanding the Independent Manager’s vote for bankruptcy, a properly authorized filing still required a 75% member vote that could not be achieved without the vote of 5532 Athens (which was controlled by PCG). Moreover, the Independent Manager requirement ceased once LHG repaid the loan, clearly tying the Independent Manager to PCG and further eroding its “independence.” Thus, the court concluded that the Independent Manger provisions were not adequately drafted to preserve the Bankruptcy Restrictions.

The court also took issue with the requirement that PCG consent to any LHG bankruptcy. Most troubling was that “PCG [had] no restrictions and no fiduciary duties to LHG that might limit self-interested decisions that ignore the best interest of [LHG].” The court, therefore, held that the Bankruptcy Restrictions as a whole “serve[d] only one purpose: to frustrate LHG’s ability to file bankruptcy;” and accordingly, were unenforceable.

Bankruptcy is a risk of doing business. Courts will scrutinize documents that purport to limit a borrower’s ability to utilize bankruptcy as a business strategy. Such limitations are rarely, if ever, countenanced. Lenders must understand this risk and underwrite accordingly.

The Delaware bankruptcy court recently decided that a debtor could not assign a trademark license absent the consent of the licensor. The court concluded that federal trademark law and the terms of the license precluded assignment without consent. Because the debtor could not assign the license under any circumstances (consent was not forthcoming), the court held that cause existed to annul the automatic stay to permit the licensor to “move on with its trademark and its business.”

The debtors (Rupari) engaged in the manufacture, sale and distribution of frozen meat products. The licensor (Roma) granted Rupari a trademark license to use the “Tony Roma” mark. After claiming a breach by Rupari, Roma purported to terminate the license. Rupari denied any breach, asserted that Roma’s efforts to terminate the license were ineffective, and eventually filed for bankruptcy.

Immediately after its bankruptcy filing, Rupari sought to sell substantially all of its assets. The sale provided that the assignment of the Roma license was a closing condition. Rupari also filed a declaratory judgment action seeking to have all license termination efforts declared void. Roma objected to the sale on the grounds that it had terminated the license prepetition (and therefore Rupari had no license to assign), and alternatively, if the license was intact, Rupari could not assign the license because Roma would not consent. While this skirmish was pending, Rupari revised its sale agreement to remove the assignment of the license as a closing condition and reduced the purchase price by $2 million. Rupari then dismissed the lawsuit.

Shortly after dismissal of the lawsuit, Roma issued a press release announcing that it had entered into a new exclusive licensing arrangement for its Tony Roma mark. Rupari reacted by filing a second lawsuit seeking a determination that Roma had willfully violated the automatic stay and renewing the declaratory judgment issues. A few weeks later, the court approved the Rupari sale without assignment of the license.

In considering the second lawsuit, the court cited federal trademark law for the general position that a non-exclusive trademark license cannot be assigned absent express authorization from the licensor. Rupari stressed that the license agreement modified this general rule since the parties previously had amended the Roma license to replace strict anti-assignment language with a provision that permitted assignment of the license (a) by operation of law or (b) in connection with a sale of all or substantially all assets but only with the other party’s consent, which could not be unreasonably withheld.

Focusing on the latter provision, Rupari argued that Roma’s refusal to consider “well-qualified prospective bidders” as assignees of the license breached the “consent not unreasonably withheld” requirement. While perhaps a meritorious position in some circumstances, the court found Rupari had effectively mooted the argument by closing the sale (without the license) before resolving the assignment issues. Because the license was not being assigned “in connection with a sale,” the consent issue was not implicated. Accordingly, citing Third Circuit precedent, the court held that because there were no circumstances under which Rupari could now assign the license, “cause” existed to annul the automatic stay to permit Roma to proceed with licensing its trademark to another licensee.

The Supreme Court has granted certiorari to decide the question of whether bankruptcy courts should apply state law or a federal rule of decision when determining whether to recharacterize a debt claim as a capital contribution.

Recharacterization presents a critical issue for lenders and investors in distressed companies. Under the bankruptcy priority scheme, secured creditors get top priority, while equity interests have the lowest priority and are often completely wiped out. A federal rule of decision more often leads to recharacterization of debt to equity than application of underlying state law.

Most circuits follow the federal rule of decision and apply a variety of multi-factor tests when analyzing whether to recharacterize debt as equity pursuant to the equitable powers granted bankruptcy courts by section 105 of the Bankruptcy Code. The Third, Fourth, Sixth, Tenth and Eleventh Circuits hold this majority view, while only the Fifth and Ninth Circuits apply state law.

In the case at issue, PEM Entities v. Levin, the Fourth Circuit affirmed the lower courts’ use of a federal rule of decision in permitting an insider’s secured loan to be recharacterized as a capital contribution. Had the courts instead applied North Carolina state law, the debt would not have been recharacterized as equity.

The United States Bankruptcy Court for the Eastern District of North Carolina did not consider the fixed maturity date, required payments, third-party nature of the loan and first-lien security given for the loan as controlling the analysis. Rather, the Court focused on the discounted price paid for the distressed loan, the lender’s failure to enforce the original loan terms prior to bankruptcy, the debtor’s poor financial position at the time of the loan purchase, the lender’s insider status, the fact that the insider made additional capital contributions to the debtor and the inability of the debtor to obtain outside financing at the time the insider purchased the loan.

We will be following the proceedings and blog the decision of the Supreme Court on this important issue.

UPDATE: On August 10, 2017, SCOTUS dismissed the petition for writ of certiorari as “improvidently granted,” ensuring that this split in the circuits will continue for the foreseeable future.

It is very common for bankruptcy court orders to provide that the court retains jurisdiction to enforce such orders. Similarly, chapter 11 confirmation orders routinely provide that the bankruptcy court retains jurisdiction over all orders previously entered in the case. The enforceability of these “retention of jurisdiction” provisions, however, will not rest on the plain language in the order but on the bankruptcy court’s statutory jurisdiction. Because no court can simply create its own jurisdiction, whether these provisions are enforceable hinges on whether the dispute in question “arises under”, “arises in” or “relates to” the bankruptcy case as set forth by statute at 28 U.S.C. §§ 1334 and 157.

Recently, the First Circuit opined that a dispute involving a provision in a chapter 11 sale order did not “arise in” the bankruptcy case merely because the sale was approved by the bankruptcy court and the sale order included a “retention of jurisdiction” provision. Gupta v. Quincy Medical Center, 2017 WL 2389407, Case No. 15-1183 (1st Cir. June 2, 2017). The First Circuit recognized that “retention of jurisdiction” provisions are not sufficient to establish “arising in” jurisdiction—instead the bankruptcy court must consider the nature of the proceeding to independently determine if the matter could arise only in the context of a bankruptcy case.

The facts underlying Gupta are relatively straightforward. Quincy Medical Center (QMC) entered into an asset purchase agreement (APA) to sell substantially all of their assets to an entity created by Steward Health Care System (Steward). The APA required Steward to offer new employment to all QMC employees that were employed immediately prior to the sale closing. The APA also provided that if Steward terminated any employee after the sale closed, then Steward would be liable for severance pay. Immediately after executing the APA, QMC filed for chapter 11 to consummate the sale and liquidate. Both the sale order and the later order confirming the chapter 11 plan included provisions retaining the bankruptcy court’s jurisdiction to determine disputes arising under or relating to the APA.

Shortly after the sale closed, Steward terminated two senior executives. When Steward failed to pay severance, the former executives sought enforcement of the APA in the bankruptcy court. The bankruptcy court determined it had subject matter jurisdiction to hear the dispute pursuant to the retention of jurisdiction language in the sale order and found Steward liable for the severance pay. On appeal, the district court reversed, finding that the bankruptcy court lacked subject matter jurisdiction over the dispute. The district court reasoned that the breach of contract claim fell outside the bankruptcy court’s subject matter jurisdiction – a contract dispute between two non-debtor parties – which could not be established by mere provisions in orders. The First Circuit affirmed.

The First Circuit explained that the “jurisdiction of the bankruptcy courts, like that of all other federal courts, is grounded in, and limited by, statute.” The scope of bankruptcy court jurisdiction is found at 28 U.S.C. § 1334. Bankruptcy courts, by reference from the district courts, have jurisdiction over “cases under title 11”, and “proceedings arising under title 11, or arising in or related to cases under title 11.” The statute provides no clear definition of “arising under”, “arising in” or “related to” and the First Circuit “observed that the boundaries between these types of proceedings are not always easy to distinguish from each other.”

The former executives did not assert “arising under” or “related to” jurisdiction; rather, they only argued that their severance claims “arise in” the bankruptcy case “because the APA was approved by the bankruptcy court in the Sale Order pursuant to [the bankruptcy code], and . . . . [the sale order] may ‘only be issued by a bankruptcy court.’” In essence, the former executives asserted a “but for” causation: “but for Debtors’ Chapter 11 case and the Sale Order approving the sale of Debtors’ assets to Steward in the APA, their claims for severance pay would not exist.”

The First Circuit rejected the “but for” test, instead holding that to establish “arising in” jurisdiction, the relevant proceeding must have “no existence outside of the bankruptcy[;]” “‘arising in’ jurisdiction exists only if Appellants’ claims are the type of claims that can only exist in a bankruptcy case.” Examples of “arising in” proceedings are typically administrative in nature – orders to turn over property, dischargeability of debts and assumption or rejection of contracts. Because the former executives’ claims were in the nature of a state law breach of contract claim, the First Circuit determined that the claims did not “arise in” the bankruptcy case and, therefore, the bankruptcy court did not have subject matter jurisdiction to determine the dispute.

Going forward, parties seeking to have their issues heard by a bankruptcy court should note that “retention of jurisdiction” provisions are not determinative. Bankruptcy courts must look beyond the “retention of jurisdiction” language and determine whether the proceeding meets the statutory test of “arising under”, “arising in” or “relating to” the bankruptcy case.

As noted in a recent Distressing Matters post, the United States Supreme Court in In re Jevic Holding Corp. held that debtors cannot use structured dismissals to make payments to creditors in violation of ordinary bankruptcy distribution priority rules. The Jevic dissent complained that the majority avoided the more general question presented—whether a bankruptcy settlement can violate the statutory priority scheme. The bankruptcy court for the Eastern District of Tennessee has addressed that complaint, holding that priority-altering settlements must be “fair and equitable” and promote a significant Code-related objective.

In In re Fryar, the bankruptcy court reviewed a settlement involving the sale of the debtor’s equity interests in two private ventures. The IRS had a lien on the debtor’s equity interests. The settlement proposed using the sale proceeds to pay off a bank lien on certain real estate, rather than using the proceeds to satisfy the IRS. In exchange for the sale proceeds, the bank would release its lien on the real estate and retain a subordinated deficiency claim. The IRS would then receive a lien on the now unencumbered real estate. The bank acknowledged that if the sale proceeds were distributed according to the statutory priorities and the bank merely foreclosed on the real estate, its recovery would be less than half of what it stood to receive under the settlement.

Three unsecured creditors and the United States Trustee objected to the settlement on the basis that it reordered distribution priorities for the benefit of the bank. The bankruptcy court agreed, noting that the settlement allowed the bank to jump “to the head of the line.” Absent the settlement, the proceeds would have gone first to the IRS to satisfy its lien on the equity, then to the estate for distribution to priority unsecured creditors (e.g., other unpaid tax claims) and finally to general unsecured creditors on a pro rata basis.

The bankruptcy court cited dicta from Jevic while considering the merits of the proposed settlement:

We recognize that Iridium is not the only case in which a court has approved interim distributions that violate ordinary priority rules. But in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve. . . . In doing so, these courts have usually found that the distributions at issue would “enable a successful reorganization and make even the disfavored creditors better off.” [Citations omitted].

Applying such guidance, the bankruptcy court determined that the settlement was more of a preamble to a conversion or structured dismissal than an anticipated reorganization and that the debtor did not prove that the settlement promoted a significant Code-related objective. Accordingly, the bankruptcy court sustained the objections to the settlement.

The bankruptcy court’s holding essentially establishes a new requirement for acceptance of any priority-altering settlement—post-Jevic, debtors wishing to consummate such settlements must now prove not only that the settlements are “fair and equitable” but also that the settlements promote a significant Code-related objective. It remains to be seen whether other courts will demand that debtors meet similar standards for priority-altering settlements.

In Nortel Networks, Inc., Case No. 09-0138(KG), Doc. No. 18001 (March 8, 2017), the Delaware Bankruptcy Court ruled on the objections of two noteholders who asked the Court to disallow more than $4.4 million of the $8.1 million of the fees sought by counsel to their indenture trustee. Given the detailed rulings announced by the Court, the decision may establish a number of guidelines by which future fee requests made by an indenture trustee’s professionals will be measured.

Matters Handled by the UCC

The noteholders’ objection asserted that the trustee had breached its fiduciary duties because it had permitted its counsel to rack up millions of dollars of unnecessary fees during litigation that was being adequately handled by the Unsecured Creditors Committee (UCC). As proof, the noteholders pointed to the fact that the litigation was ultimately settled by counsel to the UCC pursuant to a global settlement which resulted in a resolution of the entire bankruptcy case. In response, the Court noted that the trustee’s fiduciary duties with respect to the direction of counsel are governed by the “prudent person” standard, but that that standard cannot be applied through the 20/20 lens of hindsight. Instead, the trustee’s actions must be analyzed in the context of the facts known at the time of the direction.

The Court observed that Nortel was an unusually long, complex and contentious proceeding in which the trustee and its counsel were required to protect the noteholders’ rights during a number of hotly contested proceedings, any one of which might have significantly and adversely affected the noteholders’ recoveries. Thus, during the case, it would not have been prudent for the trustee to rely solely upon counsel to the UCC to protect the interests of the noteholders. The fact that the case was ultimately resolved by the efforts of the UCC was not dispositive since, at the time, the trustee could not have prudently assumed that result. The Court did, however, contrast the litigation issues which might have directly affected noteholders with matters, e.g., attendance at regular meetings of the UCC, which only affected general unsecured creditors as a whole. Those latter issues were in fact being adequately handled by counsel to the UCC, and fees for more than one counsel representing the trustee at regular meetings of the UCC would be disallowed.

Transition Fees

The noteholders objected to fees charged by the trustee’s predecessor counsel for time spent transitioning the representation to the trustee’s current counsel. The Court found, as an evidentiary matter, that predecessor counsel had been uncooperative during the transition process, thereby necessitating more work by successor trustee counsel. Accordingly, it sustained the noteholders’ objection based upon predecessor counsel’s “nonfeasance.”

Fees for Defending Fees

The noteholders objected to fees incurred by the trustee in defending the fee objection, citing the U.S. Supreme Court’s recent ASARCO case which stands for the proposition that lawyers cannot recover fees for defending their own fees in a bankruptcy proceeding. The Bankruptcy Court noted, however, that ASARCO allowed an exception where one party had contractually agreed to pay the fees of the other party. The Bankruptcy Court ruled that the indenture was such a contract because it required the debtor to pay the fees of trustee’s counsel and, in any event, granted the trustee a charging lien on any recovery owed to the noteholders.

All told, of the $8.1 million in asserted fees, the Bankruptcy Court sustained the noteholder’s objections to the extent of $913,936.70. The Court specifically remarked that it was generally unsympathetic to the noteholders’ complaints in light of the fact that the noteholders had never objected to counsels’ fees until near the end of the case.

In general, Nortel is a favorable decision for indenture trustees and their counsel, which stands for the proposition that fees should not be second-guessed with hindsight so long as there is a reasonable need to protect the specific interests of the noteholders.

One of the most powerful and oft used devices in bankruptcy is the sale of assets “free and clear” of liens, claims and interests. One issue a buyer at a bankruptcy sale must consider, however, is whether due process has been met with respect to parties whose liens, claims and/or interests are released through such sale. Indeed, a lack of due process could foil a “free and clear” sale, leaving a buyer with an encumbered purchase and nowhere to turn for recourse.

In In re Olsen, a Wisconsin bankruptcy court considered whether the failure to provide formal notice to a party with a right of first refusal (ROFR) on certain of the debtor’s real estate (Property) voided the court’s “free and clear” sale order. The court held that the sale process did violate due process and that the effective remedy was honoring the ROFR in a subsequent (post bankruptcy) sale of the Property.

In order to maximize the going concern value of its grain facility business, the debtor sought to sell substantially all of its assets in conjunction with its plan of reorganization. Archer-Daniels-Midland (Purchaser) purchased the assets, including the Property. Subsequent to the conclusion of the bankruptcy case, the Purchaser sold the Property to a third party. Country Visions Cooperative (Objector), the holder of the ROFR, sued the Purchaser in state court and asserted its ROFR. The Purchaser countered by moving to reopen the bankruptcy case to enforce the confirmation order and bar the Objector’s state court proceeding.

In upholding the ROFR, the bankruptcy court found three important undisputed facts: (i) the Objector was not listed as a creditor of the debtor, and did not receive formal notice of the bankruptcy case, (ii) the Objector never received formal notice that the Property was to be sold free and clear of the ROFR, and (iii) the Objector never received the contractual notice that the Property was being sold as required by the ROFR.

Notably, the Objector did receive informal notice of the bankruptcy case and may have even learned about the sale shortly before closing. However, such notice was not “notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections”—as due process requires. Thus, the bankruptcy court concluded that the Objector did not receive sufficient notice before its ROFR was purportedly extinguished.

The Purchaser argued that notwithstanding the faulty notice, the court should enforce the confirmation order to strip the ROFR because the Purchaser was a bona fide purchaser that acquired the Property in good faith under section 363(m) of the Bankruptcy Code. The court rejected this argument, explaining that a bona fide purchaser cannot have notice of a prior adverse claim.

Here, the Purchaser did have prior notice of the ROFR (even if the notice was constructive) because the ROFR was properly recorded. The Purchaser also had received an email indicating that someone had a ROFR on the Property. The court explained that the Purchaser easily could have commissioned a title report and ensured that all parties in interest received due notice. The court acknowledged that the debtor should have properly noticed all parties in interest, including the Objector, but also found that the Purchaser could not “cloak itself with the mantle of a bona fide purchaser when it ignored information suggesting the [Objector’s] rights were not addressed in the sale.” Thus, the court approved the Objector’s request to enforce its ROFR in the Purchaser’s post-bankruptcy sale of the Property.

In sum, a buyer in bankruptcy should consider independently ensuring that all parties with purported liens, claims or interests in the sale assets receive proper notice of the sale; hoping that the debtor provides proper notice may not be sufficient. A little effort up front can save time, money and aggravation in the end.

In a recent decision (“Energy Future Holdings”) poised to have wide-reaching implications, the Third Circuit Court of Appeals reversed the decisions of the Bankruptcy and the District Courts to hold that a debtor cannot use a voluntary Chapter 11 bankruptcy filing to escape liability for a “make-whole” premium if express contractual language requires such payment when the borrower makes an optional redemption prior to a date certain. In so doing, the Third Circuit expressly rejected the reasoning of the Southern District of New York in the Momentive decisions, which reviewed similar language and held that no “make-whole” was due. The Momentive decisions are under advisement by the Second Circuit Court of Appeals, setting the stage for a potential circuit split.

In Energy Future Holdings, the debtor (“EFIH”) filed for bankruptcy for the explicit purpose of refinancing the debt at favorable interest rates (saving over $13 million per month) and avoiding its obligation to pay the make-whole premiums to both its first and second lien noteholders. Several weeks after the bankruptcy filing, EFIH executed this strategy and the noteholders objected. Both lower courts approved of EFIH’s actions, finding that the section of the indenture that accelerated the debt upon bankruptcy did not mention the make-whole payment, therefore none was due.

The Third Circuit took a different view of the two relevant provisions in the indentures: Section 3.07, which provided that at any time before December 1, 2015 the notes could be redeemed for 100% of the principal amount plus, inter alia, the make whole payment, and Section 6.02, which provided that upon a bankruptcy filing, all outstanding notes are due and payable immediately.

The Third Circuit found that these two provisions are not at odds with each other, and that New York law requires that that both provisions be given effect. The concept of “redemption” (as opposed to prepayment), under both New York and federal law, is not limited to only repayments of debt that predate its maturity; rather, redemption includes both pre-and post-maturity repayments of debt. The redemption by EFIH was optional, despite the automatic acceleration of the debt under Section 6.02, as (i) EFIH voluntarily filed for bankruptcy, (ii) EFIH could have reinstated the accelerated notes’ original maturity date, and (iii) EFIH redeemed the notes over the noteholders’ objections. To the Third Circuit, after reviewing the relevant indentures and the facts of the payments, “Redemptions, not prepayments, occurred here, they were at the election of EFIH, and they occurred before the respective dates [in the indentures].”

It remains to be seen whether the Second Circuit will agree with the analysis of the Third Circuit concerning almost identical operative sections of the respective indenture agreements, or whether it will uphold the lower courts’ decisions in Momentive. Under the Third Circuit’s holding, however, borrowers in that jurisdiction seeking the ability to avoid payment of the make whole upon acceleration of the debt need to make that expressly clear in the governing contract.

Mintz Levin was recently honored at the 10th Annual M&A Advisor Awards dinner with the Restructuring Community Impact Award in connection with the Acquisition of Assets of Alsip Acquisition, LLC by Paper Mill Acquisition LLC. Mintz Levin’s Richard Mikels, Kevin Walsh, Charles Azano and Eric Blythe served as debtor counsel during the transaction.

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